Topic 10: Alternative Assets, Hedge Funds & Private Equity

What are alternative assets?

Assets that differ from traditional investments like stocks and bonds, including hedge funds and private equity.

What is a hedge fund?

An investment pool that employs various strategies to earn active returns for investors.

What does NAV stand for in hedge funds?

Net Asset Value, representing the value of an investor's stake in the portfolio.

What are the key differences between hedge funds and traditional assets?

Differences include transparency, investor types, liquidity, and investment strategies.

What are the differences in transperency?

Traditional Assets

• Mutual funds are subjected to the securities act of 1933 and the investment company act of 1940

• Require transparency and predictably of strategy

• periodic public updates on portfolio composition

Alternative Assets

• Hedge funds and private equity funds set up as limited liability partnerships (LLPs) or Limited Liability companies (LLCs)

• requires to provide ONLY minimal information on strategy and portfolio composition

What are the differences in investors?

Traditional Assets

• Investors

• institutions

Alternative Assets

• Accredites

• Net Worth

• Income requirements

• Professional Certification Requirement

• Knowledge Employees in Private Funds

What are the differences in Investment Strategies

Traditional Assets

• Avoid Style Drift - not to stray away from thesis

• Limited leverage

• Limited short sells

• Restricted derivative use

• Less Flexible

Alternative Assets

• Hedge funds - the Wide World of Hedge Funds

• May act opportunistically as conditions change

• Private equity

• created to invest in wide areas of investments

What are the differences in Liquidity?

Traditional Assets

• Higher Liquidity

• Liquidity needs

Alternative Assets

• Lock-up Period (Hedge Funds and Private Equity) - lock investments that can be taken away until expiration

• Redemption Notices - notify months and weeks in advance

• Structural illiquidity (real estate, collectibles)

What are the differences in Fee Structure

Traditional Assets

• Management Fees - Fixed percentage of assets under management

Alternative Assets

• Management Fees - Fixed Percentage of assets under management typically 1% to 2%

• Incentive Fees - A fraction of profits typically 20% beyond some benchmark

What is private equity?

Investment pools that aim to generate value through direct impact on firm operations

What are angel investors?

Wealthy individuals who invest in the earliest stages of business development.

What is a leveraged buyout?

A strategy where private equity uses borrowed funds to acquire publicly traded firms.

What are real assets?

Physical assets like real estate, natural resources, and commodities.

What are structured products?

Combinations of securities and derivatives designed to generate custom market-linked outcomes.

What is the liquidity difference between alternative and traditional assets?

Alternative assets often have lower liquidity and may have lock-up periods, while traditional assets are generally more liquid.

What is the typical fee structure for hedge funds?

Management fees are a fixed percentage of assets, and incentive fees are a fraction of profits, typically around 20%.

What are directional strategies in hedge funds?

Strategies that involve straightforward bets on which market sector will outperform others.

• are straighforward bets

What are nondirectional strategies in hedge funds?

Strategies that do not bet on the broad market but exploit temporary misalignments in relative pricing.

• Not betting on broad investment, instead, you buy one type of fund and sell another

What is statistical arbitrage?

A market-neutral strategy using quantitative systems to identify misalignments in relative pricing.

What is portable alpha?

A strategy that involves investing in positive-alpha positions and hedging systematic risk.

What is a term sheet in venture capital?

A written agreement specifying the deal structure, including stock type, dividends, and ownership terms.

What is the vintage year in venture capital?

The first year of a venture fund when capital is first deployed, influencing expected fund performance.

What is the role of General Partners (GPs) in venture capital?

GPs control the funds under management and make investment decisions.

What is the role of Limited Partners (LPs) in venture capital?

LPs provide capital to the venture funds managed by GPs.

What is the expected exit multiple for a VC investment?

The target return on investment, often expressed as a multiple of the initial investment.

What does dilution mean in venture capital?

The reduction of ownership percentage due to additional rounds of financing.

What is the typical capital multiplier used in private equity valuation?

A factor used to determine the required ownership per dollar invested.

What is the significance of the capital invested in venture capital?

It determines the ownership share and potential returns based on the forecasted terminal value.

What are the two forms of venture capital?

Independent VC funds and corporate venture capital.

What is the purpose of hedge fund strategies?

To generate returns by exploiting market inefficiencies and relative pricing.

What is the typical structure of hedge funds?

Often set up as limited liability partnerships (LLPs) or limited liability companies (LLCs).

What is the impact of market conditions on hedge fund strategies?

Hedge funds may act opportunistically as conditions change.

What is the goal of a market-neutral strategy?

To exploit relative mispricing while avoiding directional bets on the market.

What is the formula for calculating the terminal ownership share in venture capital?

Initial Investment × Capital Multiplier × Terminal Ownership Share = Forecast Terminal Value

If a venture capitalist invests $2,000,000 for a 22.22% ownership, what is the initial company value?

$9,000,000

What is the premoney value if the initial company value is $9,000,000 and $2,000,000 is invested?

$7,000,000

What percentage of equity do LBO funds typically invest?

10% to 40%

What is the typical debt percentage used in leveraged buyouts (LBOs)?

60% to 90%

What type of companies do LBO funds typically seek?

Mature companies with stable cash flow and lower debt

What is a common exit strategy for LBOs?

IPO or acquisition, typically 10 years from initial purchase

What performance metrics are used to measure hedge fund performance?

Excess Sharpe ratio, alpha, and information ratio

What trend has been observed in hedge fund performance metrics since 2010?

General downward trend in excess Sharpe ratio and information ratio

What is backfill bias in hedge fund reporting?

Funds report returns only if they choose, leading to non-representative prior performance

What is survivorship bias in hedge fund databases?

Unsuccessful funds that cease operations stop reporting returns, leaving only successful funds

What are tail events in finance?

Extreme but rare events that fall into the far-left tail of the probability distribution

What is Jensen's alpha?

The average return on the portfolio over and above that predicted by the CAPM

How is the information ratio calculated?

Alpha of the portfolio divided by the nonsystematic risk of the portfolio

What is a high-water mark in hedge fund management?

The previous value of a portfolio that must be reattained before charging incentive fees

What is the distribution structure in private equity chasing waterfalls?

Initial distributions flow 100% to LP until invested capital is returned, then to hurdle rate

What is the hurdle rate in private equity?

A minimum return (often 8%) that must be achieved before incentive fees are distributed

How is carried interest collected in private equity?

Through a catch-up provision until parity is reached, then 80% to LPs and 20% to GPs

What is the internal rate of return (IRR) for an LBO that sells for $350,000,000 with $91,000,000 in debt?

Equity is $259,000,000, IRR calculation needed for precise value

If a hedge fund has $2,100,000 AUM and a 1.50% fee, what is the annual management fee?

$31,500

What is the formula for calculating the final equity position in venture capital?

Final equity position = (Estimated exit value - dilution) / Initial investment

What is the significance of the term 'grandstanding' in venture capital?

Bringing companies to the public market too early may damage VC reputation

What is the relationship between private equity performance and the IPO market?

Performance varies greatly and is correlated with the strength of the IPO market at exit

What role do industry-specific VCs play in the performance of publicly traded companies?

They tend to perform better and survive longer than those backed by generalist VCs